Shake Up the Dow!

The venerable Dow Jones Industrial Average is at risk of becoming irrelevant if it doesn't find a way to admit Apple and Google. Among the companies that could get the boot: Hewlett-Packard, Alcoa and Bank of America.

Yet admitting Apple or Google -- or any other high-priced stock -- would be difficult, given the way the index is calculated. Rather than weighting component companies based on market value, as the Standard & Poor's 500 and most other major indexes do, the Dow weights its 30 components based on the absolute price of their shares

With a price of around $605, Apple's shares would overwhelm the index with a 26% weighting. That is double the influence of current Dow component
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(IBM), whose $207 stock price gives it a 12% weight in the index. Given its big daily swings, Apple alone could move the Dow regularly by 100 points or more. (The 9% jump in the stock after Apple reported blowout earnings last week, would have lifted the DJIA by nearly 300 points.)

As for Google, it is planning a stock split that would cut its share price in half, to about $300. But even at that level, it would have a hefty 15% weighting in the average.

One solution would be to adjust the way the Dow is calculated, capping the weighting of any stock at a fixed percentage, say 10%, which would ease the way for Apple and Google to enter the DJIA. Other potential index additions include
Berkshire Hathaway
and
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(WFC), which pose no problem under the current calculation system because Berkshire's class B shares (BRK/B) fetch around $80, and Wells Fargo traded late last week at $34.

Candidates for Inclusion

Apple and Google are the leading candidates to enter the Dow Industrials if the Dow's guardians find a way to handle their high stock prices. Alcoa will probably be the next stock to come out of index. Other vulnerable Dow members are Bank of America and Hewlett-Packard.

Market

Likely

Recent

Value

Index

Company/Ticker

Price

(bil)

Weight

Comment

Apple /AAPL

$608

$568

26%

Index committee should find way to add Apple

Google /GOOG

615

201

15*

Important and valuable company also should be in Dow

Amazon.com /AMZN

227

102

10

No need to add Internet retailer: It doesn't earn much

Berkshire Hath./BRK-B

80

199

4

High profits, high stock price make it a good candidate for inclusion

Wells Fargo /WFC

34

179

2

Most valuable financial company merits look as DJIA addition

Oracle /ORCL

29

144

2

With five tech stocks in the Dow, the database outfit may not make cut

*After pending 2-for-1 stock split. Source: Bloomberg

The three most likely stocks to come out of the Dow are Alcoa,
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(BAC) and Hewlett-Packard. Alcoa probably would be the first to go because its $11 billion market value makes it the smallest stock, by far, in the average. And given its price around $10, it has very little impact on the Dow. A 50% move in Alcoa would push the index up by just 38 points. Bank of America shares are now near just $8, while HP, at $25, is down 50% over two years, and has ceased to be a tech bellwether.

The Dow, which took its modern form in 1896, is calculated in an old-fashioned way, by adding up the share prices of its 30 components and then multiplying the sum by a variable, now set at 7.58, to get the current index value of 13,228. This allows the index to be tallied with a pencil and paper. (Multiplying the sum of the 30 stock prices by 7.58, or dividing the sum by a variable divisor, currently 0.132, enables the value of the average to remain constant whenever components change.)

BEHIND THE DOW'S APPLE PROBLEM is the growing unwillingness of companies to split their shares. Corporate executives seem to take pride in having high-priced stocks, and individual investors no longer are intimidated by them. "Nobody is scared of a $100 stock or a Google or Apple at $600," says Howard Silverblatt, the senior index analyst at S&P.

For most of its existence, the Dow was regularly rebalanced when companies with high-priced shares split them, with a two-for-one split cutting a component's weighting in half. It used to be common for a company to announce a split when its shares topped $100, and splits often occurred at even lower prices as companies sought to keep their stocks in the $30-to-$40 range, so that individuals could more easily afford a "round lot" of 100 shares.

"A system that worked for over a century may need to be adapted to include higher-priced stocks," says Silverblatt. He acknowledges that changing the DJIA's format won't be easy, which may be why an Apple-friendly alteration hasn't happened yet.

Silverblatt says that any changes "would have to be functional, understandable and maintain the integrity of the index." This is especially important because a large exchange-traded fund, the
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(DIA), known as the Dow Diamonds, and other index funds track the Dow Industrials. If index members are capped in their weighting, there would have to be a rebalancing policy, perhaps annually, to enforce the weightings.

There's precedence for a capped weighting because the Nasdaq 100 index, the basis for the popular exchange-traded fund
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(QQQ), now limits the weight of any member to 24% after cutting Apple's weighting to 12% from 20% in a surprise special rebalancing last year. A 10% Dow cap could also limit the already sizable impact of IBM, if the index's guardians want to apply a threshold to existing components. If Apple's weighting were capped, only part of its daily moves would be reflected in the Dow.

Another solution would be to scrap the Dow's price weighting entirely and move to a market-cap system like the S&P 500. That, however, would destroy one of the distinctive qualities of the Dow, and make it resemble the S&P 500.

None of these ideas sit well with John Prestbo, the executive director of the Dow Jones Indexes, including a capped weighting for Apple. "It would be a methodological mess," he asserts. "You'd have a 29½-stock index."

"My job and that of the index committee is to administer the Dow so that it does its job of reflecting the stock market, not to get companies into the Dow that people want," Prestbo says. "Everybody is in love with Apple because it keeps defying gravity. That doesn't mean the Dow isn't doing its job of reflecting the market. Apple certainly qualifies in every respect except one, price."

The reality, however, is that the Dow amounts to a 20- or 25-stock average now, because the lowest-priced stocks matter little. Bank of America is up 50% this year, the best percentage gain of the Dow 30, but its effect has been minimal because of its low price, chipping in just 20 points, or 2%, of the index's 1010-point gain in 2012. IBM, the key driver in recent years, has led the Dow in 2012, accounting for 16% of the index's rise, even though its percentage gain is a more modest 12%.

SOME AGREE WITH PRESTBO that it isn't worth tampering with the Dow to include Apple or Google. "The Dow is still a relevant and important indicator that tracks the market closely," says Jeff Rubin of Birinyi Associates, a stock-market-research and money-management firm in Greenwich, Conn. "It's what the individual investor focuses on."

Rubin questions, however, whether the lowest-priced stocks need to be in the index because they have so little impact. He points out that the correlation of the Dow Industrials with the S&P 500 is more than 90%. This means the two indexes tend to move together, although not in lockstep. The Dow bested the S&P 500 in 2011, rising 8.4% (including dividends), better than the 2.1% total return in the S&P 500. So far this year, the S&P 500 is ahead, with an 11% gain, 3 percentage points better than the Dow, largely due to Apple's 50% gain.

In the past five years, the Dow, even without Apple, has returned 3% a year, on average, compared with 1% for the S&P.

Prestbo acknowledges the split issue, saying, "If current trends continue unabated, we would have to take action. All 30 stocks must work together to tell the story of the stock market." That could mean the addition of higher-priced stocks such as Berkshire to dilute the impact of IBM, or perhaps even IBM's removal if its stock continues to rise and is not split.

The fate of the Dow could soon be in the hands of Standard and Poor's because its parent,
McGraw-Hill
(MHP), agreed last November to form an indexes joint venture with
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(CME), parent of the Chicago Mercantile Exchange, which now owns 90% of Dow Jones Indexes. McGraw-Hill would hold 73% of the combined business, CME, 24%, and Dow Jones, 2.6%. Dow Jones, the parent of Barron's, is owned by News Corp. The deal should close in the next few months, pending antitrust approval.

The Dow has no timetable for shuffling its components, but a new company or two might be added in the coming year, given that the last change occurred in 2009, when
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(TRV) replaced
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0.3421142661648991% Rev. per Employee
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(C), whose stock had been hammered in the financial crisis and fell below $5, making it meaningless in the average. Citi has since had a one-for-10 reverse split. Since 1991, half of the stocks in the Dow 30 have been replaced.

Same Companies, Different Weightings

The 30 stocks in the Dow Jones Industrial Average also are in the S&P 500 index but they generally have much different weightings in the Dow due to the index's price-weighting methodology. IBM is No. 1 in the Dow while Apple, not shown, is the top stock in the S&P, because it has the index's largest market value.

As the largest company by market value and one of the biggest measured by profits, Apple deserves to be in the Dow, and so does Google, which has turned its dominant search engine into a lucrative advertising business; the company has a market value of $200 billion. Apple is the leading stock in the S&P 500 with a 4.5% weighting. It is harder to make a case that
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(AMZN) needs to be in the Dow. While Amazon has a lofty market capitalization of $102 billion, its emphasis on growth at the expense of earnings resulted in profits of just $631 million last year.

If the Dow committee doesn't find a way to include high-priced stocks like Apple and Google, the next addition might be Berkshire Hathaway, whose relatively high class-B stock price, at $80, would make it an influential Dow member. Berkshire's class A shares fetch $120,000 and haven't been split since CEO Warren Buffett took control of the company in 1965. Now valued at $200 billion, Berkshire is far more than Buffett's investment vehicle, given its holdings in dozens of businesses, including the Burlington Northern Railroad and Mid-American Energy, which together produce $12 billion of net income annually.

Apple probably would guarantee its admission to the Dow if it splits its shares by five-for-one or 10-for-one, but that doesn't look likely any time soon. Apple hasn't split its shares since 2005, and CEO Tim Cook said on a recent conference call that it doesn't see any benefit from doing so now.

Google effectively will split its shares two-for-one through the creation of a new class of nonvoting stock, but that move seems motivated more by the desire of its founders, Larry Page and Sergey Brin, to retain control than by a desire to create a lower-priced stock. Page actually has been dismissive of stock splits, calling them "stupid" when an employee brought up the idea, according to Ken Auletta's book Googled: The End of the World as We Know It. Page reportedly said, "If you own 10 shares at $40, or one share at $400, it's the same thing! You just need to know how to divide."

The Dow remains the most widely followed market index, even with its quirks and archaic calculation method. Yet the guardians of the Dow need to ensure that this benchmark, created in the 19th century, stays relevant for a 21st- century market.